INTERNATIONAL

CAPITAL

BUDGETING

Nobody can really guarantee the

future. The best we can do is size

up the chances, calculate the risks

involved, estimate our ability to

deal with them, and then make our

plans with confidence.

--- Henry Ford - II

INCREASE

IN REVENUES

WHY NEW

PROJECTS

REDUCTION

IN COSTS

A FOREIGN PROJECT THAT IS PROFITABLE

WHEN VALUED ON ITS OWN MAY NOT BE

PROFITABLE OTHERWISE.

FOREIGN INVESTMENT DECISION PROCESS MAY BE

VIEWED AS AN INTEGRAL UNIT OF MANY ELEMENTS

THAT ARE INTERRELATED.

Foreign Investment Decision Process

* The decision to search for foreign investment

* An assessment of the political climate in the

host country

* Examination of the overall strategy

* Cash Flow Analysis

* Required Rate of Return

* Economic Evaluation

* Selection

* Risk Analysis

* Implementation

* Expenditure Control

* Post Audit

Search for Foreign Investment

* Profit Opportunities

* Tax Policy

* Diversification Strategies

* Environmental Forces

* Organisational Factors

* Drive by some High Ranking officials inside a

Company

Political Climate

* Host country gives priority to projects that

reduce the country’s need for imports.

* Political actions such as exchange controls and

discrimination, adversely affect company

operations.

Company’s Overall Strategy

The analyst must assess the usefulness of each

alternative within the company’s overall strategy to

determine how foreign operations may perpetuate

current strengths or offset weaknesses.

Cash Flow Analysis

* Tax Laws

* Import Duties

* Exchange Rate

* Sales Creation

* Cannibalisation (Loss to present sales)

* Fees & Royalties

* Intangible benefits (learning)

* Exchange Rate

* Expropriation

Cash Flow Analysis

Two sets of Cash Flows for Analysis

(a) One for the project itself

(b) One for the parent company

Cash Flow DeterminationAt the Subsidiary Level

Sales Less : Cash Operating CostsLess : Management fees charged by parentsLess : Royalties, Licences, Brand charged by parentsLess : DepreciationLess : Amortisation of Technology transfer EBTEarnings Before Tax (EBT)Less : TaxesEarnings After Tax (EAT)Add : DepreciationAdd : AmortisationCash Flow After Taxes (CFAT)Add : Salvage Value & Recovery of WC of last year

Cash Inflows to the Parent

* Dividend Received

* Interest Received

* Management Fees

* Royalties, Licences, Brands etc.

* Gains due to transfer price adjustment

* Terminal Cash Flows – net of all types of taxes –

sums not received because of exchange

control

* Increase in cash profits (after taxes) or less

decrease in cash profits

Cost of Capital

Discount Rate – Required Rate – Minimum Rate

The cost of capital is in effect the MAGIC NUMBER

used to decide whether a proposed foreign

investment will increase or decrease the firms stock

price.

Economic Evaluation

Once cash flows and cost of capital are known –

process of evaluating investment projects.

* Pay back period

* ARR

* NPV

* IRR

Which is Good

Selection

* Accept – Reject decision

* Mutually Exclusive Choice

* Capital Rationing

Adjusted Present Value : PV Technique – Discounts

different cash flows at different rates – depending

upon risk associated with each cash flow.

Risk Analysis

* ADJUSTMENT IN CASH FLOWS

* ADJUSTMENT IN DISCOUNT RATE

IMPLEMENTATION

Control – Complete within established guidelines.

Was or has the

Post Audits project been a

success

What makes International Capital Budgeting different

from domestic Capital Budgeting

* Project Cash Flows and Cash Flows to the

Parent Company

* Factor of Political Risk

* Inflation & Exchange Rate changes

Financial Tools

No doubt Financial Tools such as pay back, NPV or

IRR can be used. But considering the additional issues

involved that affect both the cash flows and the risk

(discount rate) make these techniques insufficient.

Adjusted Present Value

AdjustedPresentValue

PresentValue of the asset cash

flows

PV of side effects

associated with

projects*

* At their respective discount rate to be discussed in last slide

Additional Issues Involved in Cross-Border Projects

* Home country or host country whose

perspective be considered

* Blocked Funds

* Loss due to lost exports

* Restrictions on Repatriation

* Taxation

* Effect on Borrowing capacity

* Concessional Loan

* Depreciation

Additional Issues Involved in Cross-Border Projects

Discount Rates to be used for different cash flows:

* Cash flows from projects (cost of equity)

* Depreciation (risk free rate)

* Borrowing capacity (risk free rate)

* Concessional Loan (competitive market

rate host country)